Dear Everyone: Stock Market Problems Are Not Directly Due To S&P Downgrade

from the how-to-read-a-market dept

This morning we posted about the total silliness of people overreacting to S&P downgrading US debt from AAA to AA+. We received a couple of "you clueless idiot" type comments, with people pointing out that this "matters" because some institutions are required by law to hold certain percentages of certain grade investments. Of course, we did mention that in the post, so I'm going to take the blame and admit that I perhaps wasn't clear enough and now will try again: my point is that it's stupid that anyone has to react because one firm (with a rather poor track record) in "rating" debt suddenly makes a slight shift in its opinion, and that such a change in opinion represents no real change in how people view the market.

My point -- which again, was perhaps not clear even though it was the final line of the post is this:

Markets are made based on the interaction of buyers and sellers. Not the (sometimes questionable) opinions of just a few firms.

Now, let's prove it. All of the press reports today are saying that the stock market collapse is due to the S&P's downgrade. And that may be true in a very indirect way (which we'll get to), but there's no way it's a "direct" response. Here's why: the S&P is saying that US debt is just ever so slightly riskier than it was before. If that's true, then the market would likely be dumping treasuries and the interest rate would be going up. Instead, the exact opposite is happening. It looks like buyers are flooding into treasuries and the interest rate is dropping. Even economists, who generally take totally opposing opinions to one another, are trying to point this out. You've got Paul Krugman (self-described liberal) complaining about people missing this point... and you've also got libertarian Arnold Kling making the same point.

Now it could be that the downgrade indirectly triggered the stock sell-off, but it's not because S&P is suddenly afraid of the US debt being less trustworthy. As Kling notes (and I suggested in my original post), the market already can determine how risky US debt is and has priced that into the market. One firm's opinion should not change that. If anything the action in the market suggests that people are rejecting the S&P's change, not freaking out because of it.

So then why is the stock market dropping? There could be a variety of indirect reasons. One might just be that some investors are generally overreacting to the news without understanding it at all, and thinking "bad news means sell." Another theory is that this move jolted some people's attention to larger problems elsewhere (mainly the fear of Italy running into trouble). But I actually tend to think that Krugman's analysis here is actually the most reasonable. He argues that the reaction in the stock market means that US policy makers are about to overreact badly, because of the S&P downgrade, and do something stupid to harm the economy even more:

And maybe, maybe there is an S&P story — but not the one you think. Arguably, that downgrade will bully policy makers into even more deflationary, contractionary policies than they would have undertaken otherwise, which has the perverse effect of making US debt more attractive, since the alternatives are worse.

But, why isn't anyone talking about a very serious problem: the fact that we allow ratings agencies to have so much power in the first place? A ratings agency is just an opinion. What's wrong with letting the market set the opinion of the likelihood of default on debt, rather than suddenly trusting firms that don't have the greatest track record?

Splitting hairs

"Markets are made based on the interaction of buyers and sellers. Not the (sometimes questionable) opinions of just a few firms."

Mike, I really agree with your overall point, but I've got a problem with this statement. Maybe I'm splitting hairs, but here's the statement I would make:

Market prices are based on the interaction of opinions of all buyers and sellers (rational or not).

Anything which changes the opinions of buyers and sellers does have an impact on the market. Yes, its stupid and insane that 3 companies with questionable motives, having conflicts of interest, and a poor track record, can have this much power, and even worse that its legislated that they do.

Ratings agency power

But, why isn't anyone talking about a very serious problem: the fact that we allow ratings agencies to have so much power in the first place?

I'm sure this was mentioned in comments to the last post, but in case it wasn't it should be noted that Dodd-Frank included two shots across the ratings agency bows: 1) it removed their exemption from expert witness liability and 2) it required federal agencies to remove "baked-in" reference to ratings agencies from the regulations they promulgate. Both of these had the potential to seriously impede the ratings agencies. In fact after the law made them responsible for their opinions they immediately began refusing to allow their ratings to be published (although the SEC appears to have given them a perpetual waiver and a bill to remove this provision has emerged from the House subcommittee a few weeks ago without much fanfare). Of course, both reforms appear to have been eviscerated through the typical process of backroom dealing and regulatory capture. Whoops!

I shake my head reading this post, as it appears to be both an attempt to pander to a certain type of web traffic, and at the same time puts forth some ideas that just aren't working out very good.

Treasuries are generally considered a safe haven. The S&P ratings change didn't do enough to US bonds to make them unpalatable, AA+ is still such a high rating that few are even at that level. The change in the rating by itself isn't enough to discourage buyers.

What you are seeing today is the "sideline" of the S&P downgrade, which is their belief that the US system currently will not recover in a manner that will increase tax revenue, and that it is likely that the US will face another recessionary period. That is much more likely to be the trigger from the S&P comments.

What you end up with is a situation that 10 year bonds yielding just under 3% a year are still much better, at least in the short to medium term, than the eonomy itself. So people are "buying into safety" and liquidating out of stocks, which during a recession are generally hit very hard.

With the European situation, there is less "good news" out there to support stocks, leaving the US treasuries as still a pretty safe haven. This concept is backed up by continued increases in the price of gold, which is the oldest "safe haven" around.

So S&P's downgrade by itself didn't trigger this, but their underlying sentiment may just have done it.

But if they don't PROVIDE the opinion, the public might come up with their own....

Perhaps it's all about control, and if the government wasn't involved in telling us what our 'opinion' of our financial market should be, people might start actually listening to the people who know what they are talking about (ie. not the rating agencies), and making decisions based on sound rational opinions, not the government sponsored opinions that they want us to have.

Or perhaps I just had too much coffee this morning.... Sometimes it's hard to tell if there is really something going on behind the scenes, or if it's just a bunch of smoke and mirrors.

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Well, Mike outlined his point pretty clearly. It sounds very well reasoned, and even includes some outside sources. Do you have anything of value to add to the conversation, or are you just nay-saying for the sake of nay-saying?? Give us some insight into why you think that's what it is. We'll wait.

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I'm reminded of that Family Guy episode where Brian reads Rush Limbaugh's book and goes all out Republican just because the Democrats are in power. I forget the term Lois used, but it was basically that Brian always took a view opposing the majority, just for the sake of opposing the majority, and it had little, if anything, to do with the actual view.

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Tech blog?

"But, why isn't anyone talking about a very serious problem: the fact that we allow ratings agencies to have so much power in the first place? A ratings agency is just an opinion. What's wrong with letting the market set the opinion of the likelihood of default on debt, rather than suddenly trusting firms that don't have the greatest track record?"

Re: Tech blog?

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Thats actually the exact point of the article you clearly failed to read....

Also, an interesting point for those of you that dont understand economics, while it might be good for investors that treasury bonds accumulate interest at a faster rate than the economy grows, you should be aware that its still probably under inflation (which is the metric that matters), and also, if the government is paying more interest on bonds it issues than it grows its revenue, then that delta will some day be paid out of taxpayers wallets.

Another thing most of you ACs dont tend to take into account (or really anyone) is that the US government might be 14.5 Trillion dollars in debt, but there is another 40 trillion in expenditures over the next 10 years the government has ALREADY LEGISLATED IT WILL SPEND that it cant pay for. Not spending that money is just as much breaking the law as spending above the debt ceiling. Basically, I don't like Obama either, but until he starts violating the separation of powers, its Congress's fault and only Congress's fault that you are in this mess.

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Under inflation? Well, that is a subject of debate, at least in the short run. A recessionary period can also including negative inflation. As an example, a -1% inflation rate combined with a 3% bond would get you net slightly better than 4% on your money. It all depends how you look at it.

With oil prices dropping rapidly, and the potential for lower consumer spending /demand in a continued recessionary period, the concepts of negative inflation (deflation) are a real possiblity.

In deflationary times, a solid, assured, AA+ bond paying 3% would be golden.

My disagreement with the article is that Mike appears to be saying that the S&P downgrade had nothing to do with this. But the full language of the S&P downgrade, and all that is run with it in the media over the weekend has made it clear that the US economy might be on track for a net 1% of less growth this year. So the big event of the downgrade isn't key, the language and spin that goes with it is.

Markets determine what happens, but it also seems like the credit-rating agencies have enough power to hugely influence what the markets eventually determine. No, it wasn't the downgrade that caused this, but I do think it was general panic caused by the downgrade that caused this.

"just ever so slightly riskier than it was before" = -634.76

FAITH is all that holds a market of PAPER together. Can collapse in a single session if a number of large "investors" suddenly decide that it's time to cash out and leave the casino.

The "Plunge Protection Team" is pouring paper dollars into the stock market to prop it up (that's why the uptick near end of most days), but it's lost effect now. And the Federal Reserve (which is neither Federal nor a "reserve") is "buying" Treasury bills to prop them up (then US taxpayers supposedly /owe/ the Federal Reserve for "money" that never existed!). -- All are RACKETS by The Rich, looting the country by way of PAPER FRAUD.

No one can really predict what will happen when faith is lost: may rally again, but you are right that this isn't sudden.

I see a country in decline. Instead of focusing on the basics to make this country stronger, this latest wake-up call has everyone pointing fingers at everyone else, including blaming the messenger S& P. SO we'll just trot along in ignorance, declining just slowly enough to remain oblivious to what's happening until it is too late.

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Who is to say that it would not have dropped regardless of the Shit & Piss downgrade? Last week Thursday was brutal, Friday was volatile as fuck so a 600 point drop today would not have been out of the question.

In fact, who is to say that the downgrade isn't propping up the market now that the rating agency is calling the piece of shit... that's right... a piece of shit and not a chocolate bar?

Has this in fact given the rating agency more credibility that they won't print AAA on the securities of those who pay their bills even if they don't deserve the rating?

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That's exactly what it is.

Hilarious. I explain in detail why it's not and your response is just to state that it is? Very convincing. However, you are dead wrong and I can prove it. If you were right, the rate on treasuries would have gone up. But it went down. So, people didn't raise the price on debt (which they would do if it was riskier), but lowered it.

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I love it when you work up a head of steam to try to argue against what I'm saying... and in the process don't realize that you actually reiterated my point. Hilarious. I mean, it's like you read the title, but then nothing in the article.

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The S&P ratings change didn't do enough to US bonds to make them unpalatable, AA+ is still such a high rating that few are even at that level. The change in the rating by itself isn't enough to discourage buyers.

In fact, it discouraged them so little the market decided they're even more valuable than before. In other words the market disagreed with S&P's assessment.

If treasury bonds are still super-safe, why did S&P downgrade them, instead of stocks? I'm still not seeing the connection you're trying to draw between the S&P saying US government debt is less reliable, and subsequently their price rising while stocks' prices fell.

Screaming fire at the theatre

S&P were rattling their sabers up until this point. So the idea that the markets are in this little bubble isolated from people trying to hit the panic button is absurd on it's face. Not only did we have the usual congressional shenanigans, we also had S&P in there increasing the tension. There threats did as much damage as the actual deed.

They were yelling fire in a crowded movie theater either way.

There are no "fundementals" in the markets, just a lot of sheep that scare easily.

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Again proving you can't even read the post I wrote. Hilarious. Dude, seriously, if you're going to disagree with me on every post it helps to actually read what I wrote. Otherwise, you might end up agreeing with me. :)

Investment schemes tend to work well until lots of people adopt them, then they stop working. Big investors like CalPERS went to hedge funds for returns that they couldn't get elsewhere. Now that magic no longer works. So investors are cashing out, causing hedge funds to liquidate. When it's all done, what will those big investors do with all that money? Treasuries? Of course not. Corporates? They are borrowed out at low rates and have more cash than they can use. Japan bonds? China just dumped ~$6b of those. That leaves bluechips, which is why Buffet is loading up.

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Pretty much this. The idea that suddenly bonds are riskier than corporate debt is crazy. Also, no offense to the corporations that have AAA ratings, rating MS higher than the US is basically like saying that MS will outlive the US, oversimplified.

By the way, this is the exact same ratings dip that Lehman took like 4 days before it went completely bankrupt, so, no, these ratings dont have an effect. The market for treasuries has an effect, not the assholes talking about it, at least not seriously.

The level of denial in the US is astonishing !!

Do you not have any concept of "cause and effect", that may be the S&P rating changing is the effect, and not the cause?

The cause of the fiscal problems the US is facting is due to its massive borrowing from foreign countries, and massive spending, and the huge waste of money going to fighting a failed and false war in the middle east.

The fact that you have a very poor manufacturing base, and are losing IP and skills to other countries are an extreemly high rate.

You dollar is going down in value, your manufacturing industry is in tatters, you are selling IP and skills to overseas and you have massive financial management problems, and massive debt.

It is not the S&P's fault, or the fault that the rest of the planet can see what it appears those in the US are incaple of seeing. The world markets reflect that fact.

OK, I'll put my conspiracy theorist hat on now

Remember, all this panicked selling is accompanied by a lot of buying at bargain prices. Wait a quarter for the big investment houses to declare monstrous earnings, again, while the average guy takes the hit, again. Don't think for a minute that the market is just reactionary; it is manipulated just as much as Pinnochio. It was just time to funnel some more wealth away from most Americans and towards the wealthiest investors. Again.